The Stock Market Looks Like A Gigantic Powder Keg, Ready To Blow

Sean MacEntee / Flickr
Stocks have held up remarkably well lately considering all of this talk about the fiscal cliff and how going over the cliff could hack multiple percentage points off of GDP growth.

However, the apparent dismissal of this impending, high-risk event with a non-zero probability may have turned the stock market into a giant powder keg.

The S&P 500 closed at 1,435 today, which is near a three-month high and just 40 points from a post-crisis high.

Meanwhile, complacency is arguably high as reflected by the low levels in the volatility index, or VIX (see below).

"The stock market appears to have adopted a surprisingly benign view that Congress and the White House will reach agreement to avert the full impact of the fiscal contraction," said Goldman Sachs' David Kostin. "Many portfolio managers now explicitly assume a deal will be struck by year end (or possibly early January) that raises taxes on upper income Americans and curbs the growth rate of entitlement spending."

This sentiment is also shared by UBS's clients.

According to a recent survey "approximately two-thirds of investors believe that an agreement will be reached by year end, with a relatively even split between pre- and post-Christmas," said Jonathan Golub, UBS's Chief U.S. Equity Strategist. "The remaining 33% believe that a deal will not be struck until next year. Of these, a little more than half expect an agreement before inauguration day on January 21."

Speaking at a luncheon today, Golub warned that there is only downside risk left in the near-term for the stock market. "The upside has already been experienced."

Golub described two scenarios that we're currently facing: 1) if we get some sort of deal, then stocks go nowhere or perhaps down because a deal is already priced in; and 2) if we don't get a deal, then the surprised market would sell-off sharply.

Effectively, there's no reason to be buying stocks until at least after early January since it seems that only bad things could happen until then.

It'll be interesting to see how things unfold in the next few weeks.

Here's a chart of volatility during the fiscal cliff and debt ceiling debates courtesy of Bloomberg BRIEF economist Michael McDonough: